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Beauty, as any artist will tell you, is often a function of symmetry. And while the revenues brought in by the fixed income, currencies and commodities divisions of investment banks over the past decade were certainly attractive, some would argue that – like a large nose – they had become a little overdominant.

The FICC divisions accounted for as much as 70% of revenues at the largest 13 investment banks in recent years, according to research by consultancy McKinsey.

In the past six months, however, a combination of economic uncertainty, a heightened regulatory environment and increased competition – with the resulting erosion of margins – have redressed the balance.

These factors have combined to shrink the FICC business, just as investment banking divisions and equities businesses have shown some signs of growth.

This has left the banks struggling to achieve the most harmonious balance within the FICC divisions themselves, a struggle that is likely to have a profound effect on staffing.

Total FICC revenues across the 10 largest investment banks reached $50bn in the first half of the year, according to research provider Coalition, down 12% against the first half of 2010.

The second quarter was particularly difficult, with FICC revenues of $18bn, down almost 44% quarter on quarter, and around 18% year on year.

It is no surprise therefore that FICC is expected to bear the brunt of investment bank job cuts, with Coalition predicting that the fixed income divisions at the 10 banks it covers will have 6.5% fewer staff at the end of the year compared with the first half. By comparison, it expects total job cuts to amount to 5.3% of staff.

Here Financial News sets out the prospects – in the short, medium and longer term – for the constituent parts of FICC divisions: credit, rates, currencies and commodities.

Credit

Credit trading, one of the central pillars of the FICC business, started to crumble during the first-half slump, with G10 credit revenues across the 10 largest banks falling around a quarter, from $12.5bn to $9.5bn, according to research by Coalition.

The flow credit business, which comprises marketmaking in more vanilla credit products, bore the brunt of the downturn, with second-quarter revenues for the Europe, Middle East and Africa region falling by roughly 50% when compared with the first quarter, according to the firm.

The sudden second-quarter revenue slump was the result of an increase in volatility caused by sovereign debt and recessionary fears, which, in turn, led to a dramatic decline in asset prices and liquidity in the credit markets.

Many banks took hits when prices of the credit instruments they had stockpiled moved out of sync with the cash instruments they were designed to hedge – a phenomenon that is described as moves in “basis”
by traders.

Tim Gately, head of credit trading for Emea at Citi, said: “Volatility in the broader market meant that dealers were unwilling to take directional views and many found themselves with outsized positions relative to market liquidity.

“Moves in the basis caused a lot of pain in people’s books during this period.”

By contrast, the structured credit business, which includes complex packages of bonds, loans and derivatives, and which was hard hit by the credit crunch in 2008, registered renewed interest among credit investors seeking yield. Some have started moving back into lightly structured deals, said bankers.

Ben Jacquard, global head of credit trading at BNP Paribas, said: “In structured credit, correlation activities have remained mostly limited to secondary flows since 2008, but volumes are picking up on credit-linked notes or funding-related products like long-term repo.”

Despite renewed confidence in the structured credit market, however, the outlook for the overall credit business is gloomy.

In the short term, bankers expect high volatility to continue, with analysts at Goldman Sachs predicting that choppy pricing in credit in the third quarter will likely lead to negative inventory marks in excess of commissions.

Meanwhile, the heightened regulatory environment will likely dampen the performance of both flow and structured credit in the long run.

According to the McKinsey research, return on equity in the flow business could fall to between 10% and 11% after banks have taken mitigating measures to minimise the impact of changes to the Basel Committee’s market risk framework.

This is on a par with an estimated cost of equity of 10.5%.

The structured credit business, meanwhile, will be hardest hit of all products, with capital requirements increasing sixfold in some cases.

Return on equity is likely to slump from a pre-crisis level of 17% to just 7% or 8%, failing to meet its cost of equity. As a result, some banks may take the decision to exit the business.

The report said: “Some markets, such as those for resecuritisations, collateralised debt obligations or credit default swap indices, may even cease to exist.”

Commodities

Commodity revenues, which have in the past accounted for just a small share of total FICC trading income, provided a bright spot in the first half of the year, standing out as the only business to experience revenue growth.

First-half revenues across the industry stood at $4.5bn, according to Coalition, up almost a third from the same period a year ago.

As a result, commodity revenues as a proportion of overall FICC revenues rose three percentage points, making up 9% of total revenues, with metals and oil producing particularly strong results.

Despite this positive trend, performance was mixed. Revenues were good in the first three months of the year but there was a decline in the second quarter, with Goldman Sachs and Barclays Capital among those to suffer most.

The second half of the year has so far seen commodity markets behaving out of character from the traditional seasonal slowdown common to July and August.

Commodities trading activity soared in the first fortnight of August as a result of the market volatility, with BNP Paribas reporting some of its highest client activity for the summer month as a result.

Dealers are also likely to benefit in the second half of 2011 by hedging activity on the back of uncertain markets, according to Jose Carlos Cogolludo, global head of sales in commodity derivatives at BNP Paribas.

Cogolludo said: “Commodity hedging activity will increase in the second half as uncertainty in the marketplace continues, and oil and gas producers remain nervous that the price of oil will continue to drop.”

While rising industrial demand is set to provide momentum to banks’ commodities businesses, these units face distinct challenges.

Commodities businesses are not immune to regulatory changes and, like their peers in FICC, will face a significant hit to return on equity.

Post-mitigation returns on equity are likely to be around 11%, according to the McKinsey research, down from 20% before the crisis.

Second, commodities units have to contend with high employee turnover, and trading houses such as Mercuria, Trafigura and Noble have in the past hired staff away.

The Coalition report said: “Commodities businesses at the leading banks experienced greater staff turnover than other product lines, caused by general market confidence and demand from firms, such as commodity trading firms and hedge funds, which do not have the same levels of regulatory constraints.”

Foreign exchange

Beleaguered shareholders looking for some cheer take note: foreign exchange dealing can still offer a higher return on equity than any other trading business.

And there are reasons to be cheerful in what is still the world’s largest capital market, even with the rest of the global economy in turmoil.

We had several record days of trading during the first half of the year. Our options business saw a real resurgence during the second quarter too.”

Thomson Reuters, which operates one of the largest multi-dealer FX trading platforms, reported its second busiest month on record during August, with an average of $166bn in currencies changing hands every day. Trading activity is up by 6.4% for the year to date compared to 2010.

For the bigger flow houses, the contribution of FX to FICC revenues remains significant.

Coalition estimates that G10 FX delivered $4bn in revenues in the first half, equivalent to 8% of total FICC revenues, while emerging market FX represents a big revenue opportunity for investment banks able to take advantage. Nevertheless, running costs are high.

The average cost of building an e-commerce platform – essential for most top-15 dealers – is in the region of $100m, said David Field, managing director of Rule Financial, a consultancy.

Margins have been eroded by competition from high-frequency traders in what is now a largely electronic market. With spreads shrivelling post-crisis, banks have been reduced to competing to the fifth decimal place of a quote.

The cost of increased regulation is already taking its toll. Changes to capital rules could ultimately reduce the return on equity in FX businesses from 30% to 19%, according to the McKinsey research.

While this is still significantly ahead of flow rates, flow credit and cash equities, investment is already being adjusted downwards accordingly, dealers say.

Market share remains concentrated in the hands of a few European and US banks. According to Euromoney magazine’s 2011 FX survey, the concentration of flow among the top five FX dealers – Deutsche Bank, Barclays, UBS, Citi and JP Morgan – remains above 50%.

Deutsche Bank’s 15.6% market share, though down slightly on 2010, is still one and a half times larger than its nearest challenger.

For those determined to keep hold of a large FX franchise, two things will be key to success, according to Fabrizio Russo, head of FX sales in Emea at Nomura – a competitive advantage in key currency pairings and a diversified client base.

Targeting flows from across other banks, corporates and real money funds is essential for a diverse revenue stream. Central bank flows will be important too, with intervention more widespread.”

But the sting in the tail may still be coming, warned Carrington at RBS. He said: “What we’re asking now is, will asset managers be deterred from putting money to market in the final third of the year?

Volatility is good in the short term, but will it deter people from entering the market? We just don’t know yet.”

Rates

G10 rates businesses continued to drive revenues from investment banks’ fixed income, currencies and commodities divisions during the first half. But, like credit, it faces severe headwinds.

Revenues derived from rates divisions across the 10 largest investment banks fell by around 12% to $14.5bn during the first half of this year compared with the same period in 2010, according to consultancy Coalition.

The figure represented 29% of total FICC revenues, making it the single biggest contributor to total FICC revenues during the period.

Rates products, which include the vast interest rate swap market – valued at $465 trillion by the Bank for International Settlements last December – allow banks and investors to hedge their exposure to lines of credit and particularly government debt, which is vulnerable to moves in interest rates.

According to the big rates houses, good performance was up for grabs in the first quarter, but low interest rates, combined with a lack of conviction among clients, are hitting the business.

Chris Willcox, global head of rates trading at JP Morgan, said: “We had an extremely good first quarter in 2011 and generally enhanced our market share.

There are competitors which built up their rates divisions in 2009 but are starting to show signs of pulling back.

The second quarter was significantly quieter across the board with clients typically already having the hedges they needed. The persistently low level of interest rates is driving the wallet size lower.”

Willcox said that some businesses had already taken “significant hits” during the third quarter and that a sharp focus on inventory management was key to preventing losses on single trades.

He said: “We took a very disciplined approach to risk management, keeping our inventory and balance sheet as light as possible.”

For rates, as with other areas of the derivatives markets, regulation is the dark cloud on the horizon.

While incoming rules are expected to have a lesser impact on highly commoditised flow products, such as interest-rate derivatives, the effect on more complicated products, such as structured interest-rate swaps and correlation swaps, could be more acute.

McKinsey estimates that the return on equity in flow rates at the largest 13 investment banks would fall from 19% to between 11% and 12% after mitigating measures, marginally above the cost of equity.

In structured products, return on equity is expected to fall from 15% to around 7% or 8%, primarily as a result of credit valuation charges, a cost imposed on non-cleared contracts.

The top 13 global banks accounted for 50% of global flow-rates revenues in 2010, according to McKinsey, a degree of consolidation that is likely to rise as those with scale invest in technology and expand their client base.

Willcox agreed that, while regulation and higher capital requirements would pose challenges for some businesses, it would also open doors for those with scale.

He said: “It is clear that regulation will result in some parts of the business becoming less profitable on a capital-adjusted basis but, at the same time, as the market becomes more electronic, with clearing more widespread, then scale is going to be an increasingly valuable asset.”